Congress enacted a new provision as part of the Tax Cuts and Jobs Act that provides tax incentives for investment in economically distressed communities. This provision allows for both gain deferral and gain exclusion, which have the potential to generate large tax savings for investors. To access these tax savings, investors need to understand and adhere to specific deadlines and definitions contained in I.R.C. Section 1400Z-2 and proposed regulations.
I.R.C. Section 1400Z-2 provides tax incentives for investment of eligible gains in “Qualified Opportunity Funds” (QOFs). These QOFs are corporations or partnerships that invest in eligible property located in a Qualified Opportunity Zone (QOZ). QOZs are designated economically distressed areas throughout the country. There are four distinct waves of tax savings available to investors:
- Deferral of the eligible gain until the earlier of December 31, 2026 or the sale of the investment
- Exclusion of 10% of the eligible gain
- Exclusion of an additional 5% of the eligible gain
- Exclusion of all of the gain attributable to the investment in a Qualified Opportunity Fund
These tax savings are available to individuals, partnerships, corporations, estates, and trusts through making an election with their tax returns. For pass-throughs, the election is available at both the entity level and the owner level. Thus, if the entity does not elect into these savings, individual owners have the option of making the election for their portion of eligible gain.
As always, in qualifying for tax savings, investors must be careful to structure and execute transactions in specific ways and at specific times. The process can be broken down into seven steps.
Step 1: Taxpayer realizes an eligible gain.
An “eligible gain” is a gain that is treated as a capital gain for federal tax purposes. The gain cannot arise from a sale to a related party and must be realized before January 1, 2027. An eligible gain could arise from the sale of appreciated stock, real estate, or a business.
Step 2: Taxpayer reinvests the eligible gain into a Qualified Opportunity Fund within 180 days of the gain realization.
Note that the taxpayer needs to reinvest only the gain realized, not the entire proceeds from the sale of an appreciated asset. Whatever amount is reinvested into a QOF within 180 days (up to the amount of total gain realized) is the amount of deferred gain.
A “Qualified Opportunity Fund” is a corporation or partnership that holds at least 90% of its assets in “Qualified Opportunity Zone Property” (QOZP). It self-certifies as a QOF by filing Form 8996, and it must pay a penalty for each month that it fails to meet the 90% requirement.
There are specific, lengthy definitions of QOZP, but we’ll stick to the basics here. Essentially, the QOZP requirement means the QOF must either operate a business within a QOZ directly, or it must invest in a business that operates within a QOZ.
Step 3: Taxpayer elects to defer the eligible gain.
Gain deferral is not automatic under this provision. Taxpayers must make an affirmative election on their tax return to defer the gain. This is done on Form 8949. If a taxpayer sells the eligible gain property at the end of the year, the taxpayer’s return may be due before the 180 day window is over and before the gain is reinvested. In this case, the taxpayer should extend their return and make the election when the return is filed.
Step 4: Taxpayer receives a 10% basis increase for the Qualified Opportunity Fund investment.
After holding the investment in the QOF for five years, the taxpayer gets a 10% basis step-up. This has the effect of excluding 10% of the deferred eligible gain. However, the taxpayer qualifies for this basis step-up only if he or she has held the investment for five years by December 31, 2026. This means the taxpayer must invest in a QOF by December 31, 2021 to qualify for these savings.
Step 5: Taxpayer receives an additional 5% basis increase for the Qualified Opportunity Fund investment.
After holding the investment in the QOF for another two years (seven years total), the taxpayer gets another 5% basis step-up. However, the taxpayer qualifies for this basis step-up only if he or she has held the investment for seven years by December 31, 2026. To accomplish this, the taxpayer must invest in a QOF by December 31, 2019.
Step 6: Taxpayer recognizes the deferred gain.
The taxpayer recognizes the deferred gain on the earlier of (1) the date he or she sells the QOF investment or (2) December 31, 2026. The taxpayer is not required to recognize the full deferred gain if the QOF investment value has decreased – the gain is reduced for the decrease in the investment’s fair market value from the purchase date.
If the taxpayer has not sold the QOF investment by December 31, 2026, this gain is automatically triggered without a liquidating event. Thus, taxpayers should prepare for this “phantom income” by setting aside some of the proceeds in order to pay the tax later.
Step 7: Taxpayer sells the Qualified Opportunity Fund investment and excludes all of the gain attributable to the investment’s appreciation.
If the taxpayer holds the QOF investment for at least ten years total, he or she has the opportunity to exclude all of the investment’s gain. There is a catch though; according to the proposed regulations, the taxpayer must sell the investment before January 1, 2048. Additionally, it is important to note that this exclusion applies only to the original “eligible gain” investment. Any amounts invested above that amount are ineligible for the exclusion.
In order to qualify for all four waves of tax savings, taxpayers must sell their eligible gain property and reinvest the gain into a QOF by December 31, 2019. The taxpayer must then hold the QOF investment for at least ten years from the reinvestment date.
Investors need to consider risk and return before investing in qualified opportunity funds. Potential tax savings are not enough to make an unprofitable investment become profitable; the underlying investment must generate a return. Investors should beware of risks, which include market, liquidity, and industry-specific risks as well as the risk that the finalized regulations will differ from the proposed regulations. They should also pay attention to fees associated with investment programs as well as brokers’ integrity and experience.
If you’re planning on selling appreciated stock, real estate, or a business, it may be the right time to invest in a qualified opportunity fund. Contact our office to learn more.
Article by Elizabeth Tolson | Edited By Jim Snyder, CPA